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COVID-19 and the global recession -the imperative need for a Keynes solution

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COVID-19 and the global recession – the imperative need for a Keynes solution

Mikael Randrup Byrialsen, Finn Olesen and Mogens Ove Madsen1

Abstract: Presently the global economy is hit by a very severe recession due to the COVID-
19 virus. The exact magnitude of this shock to the world economy is uncertain, but many
believe that the setback in GDP will be on a scale similar to, if not worse than, the first
years of the Great Recession. As such, there is an imperative need for policy actions of a
Keynesian nature, as have already been implemented in many countries. In the present
paper, with Denmark as a case study, using an SFC modelling approach, some aspects of
the negative economic impact of the COVID-19 virus on the Danish economy are
highlighted, as are the consequences of the policy actions adopted by the Danish
Parliament.

Keywords: COVID-19 , global recession, SFC modelling & fiscal policy

JEL-codes: B22, E12, E37 & E62

1
Aalborg University, MaMTEP, Department of Business and Management. Corrosponding author:
randrup@business.aau.dk.
We would like to express our gratitude to Robert Smith. All the usual disclaimers apply, and all errors or omissions are
entirely our own.
1 Introduction
The dramatic impact of the Great Recession on global economic performance, and the slow and irregular
recovery of many countries over the past decade has led to the fear in a growing number of economists of a
potential scenario of secular stagnation. Even with the inclusion of a number of mainstream economists. The
preceding agenda, concerned predominantly with the attempt to make minor adjustments to stabilize the
economy around a given trend – the optimal intertemporal path of full employment – in the short run seems
to have lost favour. Amid growing insecurity and concern as to why post-recession levels of GDP had not
recovered to the pre-recession trends, Summers (2014:69) commented: ‘that the record of industrial
countries over the last 15 years is profoundly discouraging as to the prospect of maintaining substantial
growth with financial stability’2. A concern affirmed by the analysis of Blanchard et al. (2015), covering
evidence from 23 advanced countries using data from 1960 onwards: post-recession output levels seem in
many cases to remain below the pre-recession GDP trends3. Secular stagnation, various kinds of hysteresis
and the monetary reality of a binding ‘zero lower bound scenario’ seem all to have found a place on the
macroeconomic agenda for good few years to come.

However, today’s scene of macroeconomics has changed dramatically. The global pandemic related to the
COVID-19 virus and the ensuing constriction of economic activity have presently, in 2020, brought the global
economy to a stand-still, with the prospect of a prolonged and severe recession to follow. The exact
magnitude of this shock to the world economy is of course uncertain, as is the length of the current recession.
However, many fear that the drop in the global GDP level will be significant. In fact, probably on a scale similar
if not worse than that of the first years of the Great Recession. As the IMF Managing Director Kristalina
Georgieva predicted in an address on March 23rd 2020:

2
Moreover, this kind of empirical evidence might give way to other perspectives on macroeconomics than that of the
dominant mainstream understanding of the New Neoclassical Synthesis. The lesson learnt seems to be that ‘it is
increasingly clear that the trend in growth can be adversely affected over the longer term by what happens in the
business cycle’ and that makes Lawrence Summers wonder ‘how satisfactory would the recovery have been in terms of
growth and in terms of achievement of the economy’s potential with a different policy environment, in the absence of
a housing bubble, and with the maintenance of strong credit standards’, Summers (2014:66 & 67).

3
’A surprising high proportion – two-thirds – of recessions are followed by lower output relative to the pre-recession
trend. Even more surprisingly, almost one-half of those are followed not only by lower output, but also by lower output
growth relative to the pre-recession trend’, Blanchard et al. (2015:17).

1
 ‘The IMF expects the global economic growth in 2020 to be negative – a recession as least as bad
as during the global financial crisis or worse. But we expect recovery in 2021. To get to it, it is
paramount to prioritize containment and strengthen health systems everywhere. The economic
impact is and will be severe. But the faster the virus stops, the quicker and stronger the recovery
will be’4.

Acknowledging this bleak and frightening forecast, there is an imperative need for quick policy actions of a
Keynesian nature as have already been implemented in many countries. A swift, politically driven, stimulus
to aggregate demand will be necessary to avoid the entrenchment of a severe recession in an environment
of deep economic pessimism in the private sectors of all economies. Macroeconomically, it is time for a good,
old-fashioned Keynesian economic policy strategy.

The following section gives a short discussion on the possible return of Keynesian economics as an important
paradigm in macroeconomics, and the succeeding sections focus on a Danish case study. First, an empirical
model for Denmark using an SFC-modelling approach is presented. Second, some aspects of the negative
economic impact of the COVID-19 virus on the Danish economy are highlighted, as are, thirdly, the
consequences of the policy actions adopted by the Danish Parliament. Fourth is a section presenting a
discussion of the results of the model scenarios. Finally, the paper closes with some concluding remarks.

2 Back to basics - did Keynes win after all?

In the aftermath of the Great Recession, many felt a need for a revision of the modern macroeconomic
mainstream – the New Neoclassical Synthesis, (NNS), and their DSGE-models. Somehow, the incumbent
mainstream failed big time to foresee the coming of the financial crisis, which later developed into a deep
international recession with huge drops in the GDP levels of most countries. Some heterodox economists
anticipated a change in the presiding paradigm. A transformation from the classical understanding imbedded
in NNS to a revival of solid old-fashioned Keynesian understanding, built on the framework provided by
Keynes in his General Theory. Based on empirical evidence and critical voices even from within – Romer
(2016) as an example – even mainstream macroeconomists saw the need for development. And as we know

4
The video can be found at https://www.imf.org/external/mmedia/view.aspx?vid=6144138845001.

2
today, mainstream macroeconomics has put some changes on their agenda (see amongst others, Galí (2018)
and Christiano et al. (2018))5.

Furthermore, non-mainstream economists have to acknowledge that today’s mainstream seems to have
adopted a sort of Keynesian understanding of the importance of the role played by aggregate demand
(although for most probably only in the short run)6. As least in this respect, the modern macroeconomic
mainstream has a Keynesian flavour.

In an interesting issue, Spring 2020, the Review of Keynesian Economics has addressed the status of Keynesian
economics. According to the various contributions, Keynesian economics is alive and kicking. Just to mention
some of the statements given in these articles, Rowthorn (2020:1 & 17) points out that ‘since the initial anti-
Keynesian counter-revolution 40 years ago, Keynesian economics has made something of a comeback …
Mainstream economists mostly believe that a fiscal stimulus is an effective way to promote recovery during
a severe recession’. Rowthorn sees this fact as a sign of some kind of convergence between mainstream and
heterodox economics7. Whereas Eichengreen (2020:24) argues that ‘Keynesian economics in the sense of IS-
LM augmented by a fully specified financial sector never died … If anything, its influence, intellectually and
over policy, increased as a result of the global financial crisis’8. Arguing that ‘Keynes’s argument that a
breakdown of capitalism is possible, due to volatility of liquidity preference and investment in a world of
uncertainty, and his analysis of how governments should cope with such crises, remain painfully relevant’,

5
For a critical assessment of the modern macroeconomic mainstream, see Marchionatti & Sella (2017).

6
That aggregate demand has an important role to play also in the longer run is known in general by any Post Keynesian;
see e.g. Skott (2016).

7
However, he warns us of important differences between the two paradigms. As an example, he points out ‘there is a
strong prior in mainstream economics that Say’s law holds in the long-run. The effect of demand shocks eventually
wears off, so the economy is driven over anything but the short period by autonomous supply forces’, Rowthorn
(2020:17). Likewise, as stated by Fazzari (2020:47) ‘despite the New Classical attempt to bury Keynes, a demand-driven
view of macro was weakened, but not killed in the decades prior to the Great Recession … In my opinion, there has been
a significant movement back toward the intrinsic Keynesian perspective, but it remains incomplete’.

8
And he points out as a fact that the slow recovery after the crisis ‘was a result of the limited magnitude, not the limited
effectiveness, of fiscal stimulus, reflecting political resistance to more forceful action … multipliers were larger in
recessions than expansions, consistent with Keynesian intuition’, Eichengreen (2020:29).

3
Dimand (2020:36), argued that the approach adopted by the NNS and DSGE modelling is much too narrow in
its scope to be able to cope with real life problems the right way9.

Therefore, as Palley et al. (2020:21) seems right in concluding: ‘We are living in a time which many believe
has a distinctly Keynesian character … its legacy remains in place in the sense that discretionary counter-
cyclical fiscal policy is back … Likewise, activist monetary policy is back’. As the global economy is again
confronted with significant difficulties, one most hope that the Keynesian perspective strengthens further
giving way to important Keynes-like solutions that might minimize the devastating negative economic impact
of the COVID-19-virus.

3 The need for collectively funded,

comprehensive social protection systems
Stiglitz (2020) has advocated for targeted assistance to help people and sectors weather the public health
emergency. He calls on us to appreciate once again the important role of government, public policy and
public values:

“It is clearly a case where targeted fiscal policy is what is needed. It’s been true for a long while that monetary
policy has had only have limited efficacy,…(but) this is a different kind of crisis than normal crises. It’s just not
a problem of aggregate demand… because of the disease, people are shutting down their businesses. In the
United States, restaurants in New York City have been closed,” says Stiglitz. “More demand is not going to
save that particular problem”.

9
Making him state that ’Those whose training was in the use of dynamic stochastic general equilibrium (DSGE) models,
or of overlapping generations models, were in the position of the person with a hammer, to whom every problem looked
like a nail’, Dimand (2020:37).

4
The novel COVID-19 virus exhibits the extent of public sector neglect after a long period of neoliberal politics.
Today, none in Europe dare to claim that private hospitals can fight the virus better than public ones.
Underpaid nurses from these public hospitals are now more precious than private health care professionals.

Proper functioning of a stronger public sector requires more creative thinking and institutional engineering
than is currently offered. There is something going on that focuses on transfers. A number of governments
have increased financial support for households and businesses.10 France, Hong Kong, Ireland and the United
Kingdom have extended sickness benefits to quarantine or self-quarantine. Germany and the Netherlands
offer partial unemployment benefits to workers whose hours have been cut due to falling demand.

Similarly, China, France, Portugal and Switzerland have expanded eligibility for unemployment benefits to
include workers in companies that have been ordered to close temporarily, while Australia, China and
Portugal have extended social assistance to vulnerable populations. And many countries - such as China,
France and Thailand - have delayed deadlines for social security and tax payments.

Interestingly, the Chinese government's statistics suggest that China may break with the long-standing
tradition and report an economic decline in the first quarter of this year. Retail sales have fallen by more than
20 percent from a year ago, as many stores remained closed well beyond the usual end of the New Year
holiday. Even when stores reopened in February, they had almost no customers until early March due to fear
of viruses. An additional fact is that industrial production fell 13 per cent in February compared to February
last year. Many factories first opened in late February. (World Economic Forum (2020, Bradsher (2020)).

In Germany, the government has announced a package that will provide additional billions of Euro to
healthcare and create a 'protective shield' around businesses and workers. The latter includes, for example,
improved conditions for applying for short-term work allowance, deferred taxation and easier reduction of
tax prepayments, extended loans and government guarantees for companies, in particular through the
Kreditanstalt für Wiederaufbau (National Development Bank).

Prime Minister Pedro Sanchez, of Spain, has announced measures to the value of USD 200 billion to help
businesses and to protect workers and other vulnerable groups affected by the escalating pandemic.
Portugal, which declared a 15-day emergency starting March 18, has unveiled a support package in support
worth more than 4% of the country's GDP. The government of France has pledged an aid package for small
businesses beyond the billions already promised to French workers forced to stop working because of store
and restaurant closures and stringent new quarantine measures. Canada's Prime Minister, Justin Trudeau,

10
The work from DW (2020) has provided information about the initiatives in different countries.

5
unveiled a Canadian stimulus package. The package is used to support businesses and provide temporary tax
relief. The package is worth 3% of Canada's GDP. Australia has announced a fiscal stimulus package to tackle
the COVID-19 virus pandemic. The package includes a one-time payment of AUD $ 750 for nearly 6.5 million
lower income Australians. The fiscal stimulus package is almost 1% of Australia's GDP.

To reduce the projected negative economic impact, the US government and Congress have made the decision
to launch an immense aid package. To put things into perspective, the relief package (TARP) launched during
the financial crisis was smaller and there is already discussion of the possibility for an additional
supplementary package.

Although these are historically dramatic fiscal measures, they will not be able to prevent a recession (in this
case, recession is meant as a sharp decline in economic growth, but must not be confused with either
depression or financial crisis) in the United States, but they can contribute to a contraction and reduction of
the depth and severity of the recession.

But where does the EU stand? The Commission has announced a COVID-19 virus investment fund, saying it
will use all the 'flexibility' available while taking away state aid rules. In April, the member states of EU have
agreed on a package to help countries, who need help to keep business alive and provide the workers with
income. Just like emergency credit lines have been established in the EU’s Bailout fund. This credit is
prioritized health spending in the member countries.

The ECB did even less after refusing to cut interest rates (unlike the US Federal Reserve and Bank of England)
or to intervene to reduce the German-Italian bond spread. Until, that is, the reversal on March 18 with the
launch of a massive bond purchase program. QE was increased by USD 120 billion added to the Asset
Purchase Program (APP) for 2020. On 18 March, the ECB, under another new acronym, Pandemic Emergency
Purchase Program (PEPP), offered a further intensification of QE.

Without a robust response at the EU level to accompany national measures, the Union is once again at risk
of dissolution. Lack of EU decisions increases the scope for national measures. However, the Commission is
proposing some re-prioritization of its own budget, although it is unlikely to be as timeous or decisive as
national efforts. It also intends to increase spending under the Cohesion Fund of unused money.

There seems to be no political mood for changing the rules of the Growth and Stability Pact - it did not happen
during the financial crisis and thus not now. Instead, it should be seriously considered opening up Corona
bonds that all states can support and which provide a much more comprehensive background for developing

6
a European recovery package. It will also mean strengthening solidarity between the South and the North -
no greater inequality between the countries is needed.

But as the COVID-19-crisis makes it clear that not enough progress has been made. If the pandemic continues,
it can be hoped that it will encourage governments to expand access to health care, sickness benefits and
unemployment protection, since such spending has a greater positive multiplier effect on the economy than
other measures.

Primary sector workers are most exposed to the pandemic, as they often lack social and human rights and
enjoy little or no social protection. This is the case for those who cannot work (the unemployed) and those
who do, but do not have guaranteed work or hours. Unfortunately, this extends to low-paid workers, with
an overrepresentation of migrants, women and young people in certain sectors in the economy, such as
cleaning, hospitality and retail.

Governments must use the momentum created by the COVID-19-pandemic to make rapid progress toward
collectively funded, comprehensive social protection systems.

4 The Danish case study

Like most other economies, the Danish economy has been hard-hit by the COVID-19-virus. After the first
COVID-19 virus related death in Denmark, the prime minister, Mette Frederiksen, announced a nationwide
lockdown of the Danish society. From March 13th all persons working in ‘non-essential functions’ in the public
sector were required to work from home. All schools and public institutions, except for hospitals and doctors’
practices, were simultaneously shut down. In the private sector, employers were asked to encourage their
employees to work from home, unless their positions were essential for society11.

As expected, the financial markets reacted immediately and dramatically to the COVID-19 virus, resulting in
sharp declines in stock market valuations – both nationally and globally. The leading Danish stock market
index OMX C-25 dropped by almost 25% over a short period of three weeks (Nielsen (2020)). According to
standard economic theory, this may lead to a fall in interest rates on long-term bonds, as speculators

11
This includes work related to production, transportation, food and groceries, pharmacies and infrastructure.

7
reallocate their financial investments from stock to more secure securities, such as bonds, which would lower
the interest on this asset. However, in the COVID-19 virus situation, the speculators seem to have left the
market completely as we have seen increases rather than expected drops in interest rates. The decision to
lock the economy down has in general increased the level of uncertainty in the economy, which may lead to
a fall in private consumption as well as private investment. The sudden fall in aggregate demand, is expected
to lead to a rapid increase in the number of unemployed persons, which can also be seen by looking at the
number of unemployed in the Danish economy. Finally, the impact of the COVID-19 virus on global demand
is expected to cause a further decline in as foreign demand for Danish exports falls. This brief description ,
can be summarised as a combination of several negative shocks to the Danish economy.

In order to avoid a catastrophic fall in economic activity and escalating unemployment, the Danish Parliament
has decided to introduce a number of aid packages on an enormous scale – to the value of DKK 287.6 billion.
The aim of this aid package is to help private sector wage earners and firms, as those employed in the public
sector continue to receive their normal wages during the lockdown. As a consequence of these packages,
corporations are compensated with up to 90 % of expenditures related to the retention of employees.12 For
the unemployed, the normal restrictions on unemployment benefits have been relaxed, and should secure a
source of income for those individuals for several additional months. Furthermore, Parliament has decided
to move forward with planned public consumption and investment. In general, Parliament has returned to a
strategy of discretionary counter-cyclical fiscal policy actions on an unprecedented scale.

In order to illustrate the need for discretionary counter-cyclical fiscal stimuli as a tool to promote a recovery
from a recession we use a Post-Keynesian empirical stock-flow consistent model, estimated for the Danish
economy as presented in Byrialsen & Raza (2020).

5 The Model
Before we present the results from the simulations, we will briefly discuss the properties of the model. Since
the purpose of this paper is to discuss the need for counter-cyclical fiscal policy and not to provide a formal
presentation of the model itself (A full description of the model can be found in Byrialsen & Raza (2020)), the
presentation is kept at a very general level. The structure of the model follows in the tradition of Godley &
Lavoie (2007), and other models that employ the Post-Keynesian SFC approach, and the behavioural

12
The requirement for receiving the aid is more complex, than presented in the text. Factors like the size of the individual
corporation and the fall in revenue as a consequence of the virus, play important role in the requirement.

8
equations are therefore based on Keynesian theory. The structural parameters in the model are estimated
using the annual sectoral national account for Denmark since 1995 from Eurostat.

The model consists of the five institutional sectors; households, non-financial corporations, financial
corporations, public sector and the Rest of the World. All production and employment take place in the sector
for non-financial corporations, and the employment is positively related to the total production in the
economy13. The income of the households consists of wages, surplus of the production, social transfers and
income on capital, while the expenditures consist of consumption and investment in housing14.

The income in the public sector consists mainly of taxes payed by the rest of the economy, while the
expenditures consist of public investment, public consumption and net social transfers. The main flows on
the real side as well as the financial side for a given year can be seen in the Sankey (Alluvial flow diagram)
below:

Figure 1: Real transactions Figure 2: Financial transactions

13
The decision to employ or fire people is therefore closely connected to changes in the aggregated demand. The level
of Investment to fixed capital ratio is assumed to be a function of the capacity utilization as suggested in most Post-
Keynesian models.

14
The consumption function is modelled in a standard way as function of disposable income and net wealth. The
investment function is assumed to be a function of disposable income, actual stock of housing, house prices relatively
to cost of new houses and credit available.

9
As seen in the Figure 1 on the left, the incomes and expenditures on the real side of the economy are
relatively detailed in the model, which permits the identification of the channels through which a given shock
to the economy is transmitted through the whole economy. Following the accounting principle behind the
SFC-models, all flows out of a sector results in inflows of other sectors. As illustrated in the Figure 2 on the
right, financial assets are assumed to consist of three asset classes: equites, interest-bearing assets and
pension assets. Aside from showing the transaction of the individual assets among the different sectors, the
diagram also illustrates which assets belong to which sector, that is, which sector holds the asset for each
counterpart liability (in net terms). The strategy in this model is to model the flows in the economy leaving
the stocks as accounting identities, where the stock in the current period is equal to the sum of the stock in
last period, capital gains and transaction in the current period. This consistent integration of stocks and flows
on both the real and financial side of the economy enables the possibility of analysing the effect of COVID-
19 virus on both real side transactions (e.g. GDP, Investment and Consumption) and financial stock (e.g.
public debt) in one comprehensive model.

6 Results
The purpose of the model is to analyse the effect of the COVID-19 virus on the economy and discuss the
effect of a counter-cyclical fiscal policy; a baseline scenario and two shocks are therefore simulated in the
model. The baseline in this model is used as a reference scenario, to represent the expected development
economy in the absence of the COVID-19 virus. Deviations from this baseline are therefore identified as the
effect of the virus, while the difference between scenarios 1, 2 and 3 are considered to be the effect of fiscal
policy measures employed. This is similar to the procedure followed in a recent report from The Economic
Council of the Labour Movement AE (2020), which builds on a scenario analysis from the Annual Danish
Aggregate Model (ADAM). The simulation results below are compared and contrasted with this report and
one conducted by the central bank of Denmark (Denmark’s Nationalbank) in the discussion that follows.

The three scenarios develop progressively, are presented in greater detail below, and can be summarised as
follows:

i) The Danish economy is exposed to a one-year (single period) shock, which is a

combination of the negative impacts related to the COVID-19 virus pandemic
presented in section three, with no intervention by the public sector.

10
 ii) Identical to scenario i), but the effects of the disturbance are allowed to persist but
diminish over several years. The public sector is again passive.
iii) Identical to as scenario ii), but in this scenario, the government introduces a variety
of help-packages.

These three scenarios allow for the analysis of both the effect of the shock and the mitigating effects of the
policies pursued by the public sector.

Scenario 1
The aim of the first scenario is to capture the negative impacts of the COVID-19 virus pandemic on the Danish
economy. These impacts are generated through changes to a number of autonomous components in the
model. Due to the fact that the effects of the pandemic cannot yet be fully observed, the adjustments to the
model parameters are based on a combination of initial effects, and experience from the most recent major
shock to the Danish economy. As noted above, these effects are introduced for a single period, and the
economy is left to self-stabilise thereafter.

The autonomous pricing parameter in the equity market is lowered by 0.2515 and the autonomous
component of the export function is lowered by 0.15. Since this scenario is assumed to affect both the
behaviour of households and investment decisions by the firms, the autonomous term in the consumption
function is lowered by 0.05, while the marginal propensity to consume is lowered to 0.4. In the investment
function for the firms, the autonomous term (often interpreted as ‘animal spirits’ to use the terminology
employed by Keynes) is assumed to fall to -0.4 as a result of the sudden negative shock to the economy.

As presented in Section 4, the Danish stock market experienced a fall of almost 25% during a period of three
weeks in February and March. In this simulation, the stock market index falls by around 20% in 2020. During
GFC in 2009 real consumption fell 3.55%. In this scenario, real consumption is simulated to fall 5% in 2020.
This result is driven by the alteration to household behaviour, which can be interpreted as the combination
of a sudden increase in uncertainty for households resulting in a decline in both the propensity to consume
and the autonomous component in consumption. Private firms are at the centre of the negative impacts of
the pandemic, and thus investment by firms is expected decline considerably. In this scenario, real
investment by firms falls by 20% in 2020. During GFC real investment by firms fell almost 24 % the first year,

15
Since the functions are estimated in logs, the changes in values approximately express percentage changes. An
! "."$
increase in a parameter of 0.05 is equal to a change in the endogenous variable of !"
− 1 ≈ 5 %.

11
so the effect is expected to be a little bit smaller this time. Finally, this scenario also reveals a drastic fall in
trades across border, reflecting the fact, that the effects on the virus are global. In this simulation, the real
export falls by 12.5 % in 2020.

The overall effect of the shock to the economy is a sharp decline in real GDP of 5.5 % in 2020, and a surge in
the number of unemployment persons by 47000 people. The magnitude of this shock on GDP is larger than
the most recent recession, but the effect on the level of unemployment is smaller.

In this relatively optimistic scenario, with a single-period shock, the recovery from the crisis is quite fast, but
despite this smooth recovery, there is a permanent effect on both the level of GDP and the level of
unemployment from this simulation. This lower post-crisis output level also seems to be consistent with the
conclusion drawn by Blanchard et al. (2015), that the post-crisis level of output is lower than the pre-crisis
level of output.

The results from this simulation, relative to the baseline scenario for the level of GDP and unemployment are
presented in the table below.

Table 1: Scenario 1: Annual impact on real GDP and unemployment

Despite the fact, that the simulated shock was a temporary single-period shock to the economy, the effects
on GDP and unemployment would be expected to be lasting. The proportional deviation of GDP from the
baseline scenario to Scenario 1 is almost -2% in 2021 and remains below -1% until 2025, and can mainly be
explained by a strong fall in real consumption and investment in the household sector as a result of a fall in
disposable income and wealth. Investment by firms falls further in 2021 as a result of the accelerator
mechanism, after 2022 the level of investment begins to recover. Net exports also improve over the period,
as exports rebound faster than imports after the one-period shock. As the gap in the level of output between
the baseline scenario and Scenario 1 contracts between 2021 to 2025, the gap in unemployment naturally
shows a corresponding contraction, and by 2025 the excess number of unemployed persons is around 8000.
Since the level of automatic stabilizers is high in Denmark, the lower economic activity creates a deficit on
the public budget, which affects the public debt to GDP ratio positively. From 2020-2025 the ratio increases
with almost 5%-point in this scenario.

12
The conclusion of this crisis-scenario is that this one-period shock hits the economy quite hard in 2020 with
a fall in real GDP of 5.5%. Despite being a one-period shock, the post-crisis level of economic activity is
permanently lower than the level predicted in the baseline, and affirms the conclusions of Blanchard et al.
(2015).

Scenario 2
In the second scenario, hysteresis effects and a feedback mechanism to the exogenous shocks are integrated
into the model after 2020. This is done by assuming that the shocks to follow an AR(1) process, with a
parameter of 0.25, which creates a stationary process with a diminishing magnitude of the shock. With
regards to the behavioural parameters this can, from a theoretical perspective, be explained by the impact
of increased uncertainty generated by the shock on the economy. Particularly, of how long is the virus is
expected to take to circulate, and what are the effects on current and future income will be.

While the results for 2020 are identical to Scenario 1, there are substantial differences from 2021 onwards.
Both the temporary and permanent loss of output is greater. The table below illustrates the effects of this
shock compared with the baseline, for the level of GDP and unemployment.

Table 2: Scenario 2: Annual impact on real GDP and unemployment

The level of GDP in this scenario is around 3.5 % lower than the baseline in 2021 – more than 1.5% points
lower than in Scenario 1. The hysteresis-effect thus aggravates the negative effects of the shock through
extended contractions in the propensity to consume and the autonomous consumption and investment
components of demand. This leads to magnification of the negative effects of the fall in disposable income
and wealth and an even more substantial fall in both real consumption and investment by households. The
persistence in the fall in the autonomous propensity to invest by non-financial corporates prolongs the
recovery phase relative to scenario 1. The extended and magnified contraction of economic activity also has
a corresponding effect on unemployment as the number of job-losses rises by 10 000 over and above those
of Scenario 1 in 2021, with a rapid by significantly reduced recovery in the succeeding years. As explained in
Scenario 1, the high level of automatic stabilizers in Denmark, creates a deficit on the public budget as a
result of the lower economic activity. Despite the passivity of the Government, the public debt to GDP ratio

13
is still affected positively and the ratio increases with almost 6.5 %-point over the period 2020-2025 in this
scenario,. This scenario illustrates the possible difference in the impact of the pandemic, depending on
whether the effects turn out to be more or less persistent. In this case, the recovery from the crisis is slower
when compared to Scenario 1 and the baseline, and the fall in GDP and the increase in unemployment are
higher in the medium term.

Scenario 3
This scenario builds on the same principles as Scenario 2, though with one important difference. Government
takes on the responsibility to dampen the negative impact of the COVID-19 virus pandemic through the use
of fiscal policy. As presented in section 4, the government has increased expenditures in several ways. In this
model scenario these expenditures are increased through three channels:

i) An increase in transfers to firms to compensate for the loss of income from the lower production
in 2020. The size of this compensation is calibrated to 60% of the expected loss of production.
ii) An increase in transfers to firms to compensate for wages paid to keep people employed instead
of firing them in 2020. This compensation is calculated as 60% of the expected drop in
employment.
iii) An increase in the public consumption of DKK 50 billion (approx. USD 7.4 billion) in 2020.

To analyse the effect of active fiscal policy, this reaction by government is also assumed to follow an AR(1)
process with a parameter of 0.6, since the Government wants to use fiscal policy as a central part in the
recovery phase to avoid too deep a stagnation of the economy.

The effects of the actions taken by government counteract the negative effects of the shock, and the fall in
real GDP for from 2019 to 2020 is -3.28%. Compared to the relative decline in real GDP in Scenarios 1 and 2
of 5.5% from the baseline. The actions from the Government are thus able to reduce the negative effects of
the shock to the economy.

14
 Effect on GDP

0
−1
−2
Deviation from baseline %

Shock1
−3

Shock2
Shock3
−4
−5
−6

2016 2018 2020 2022 2024

Year

Figure 3: Effects on GDP

The number of unemployed persons increases with 31000 from 2019 to 2020 as a result of this shock, which
is significantly lower, than the increase of 47000 from Scenarios 1 and 2 as seen in Figure 4 below:

Effect on level of unemployed

50
40
Deviation from baseline − 1000 persons

30

Shock1
Shock2
Shock3
20
10
0

2016 2018 2020 2022 2024

Year

Figure 4: Effect on level of unemployment

This policy, determined by government, clearly has negative effects the public sector budget, as expected,
and results in a large government deficit and a corresponding increase in the debt-to-GDP ratio for the public
sector.

15
 Effect on Public Debt to GDP ratio

15
10
Deviation from baseline − %−point

Shock1
Shock2
5

Shock3
0
−5

2016 2018 2020 2022 2024

Year

Figure 5: Effect on Debt-to-GDP-ratio

The aim of this scenario is to illustrate the potential for fiscal policy measures to minimise the gap between
actual economic activity and the baseline scenario in the medium term. For 2024 and 2025 the deviation
between the results from Scenario 3 and the baseline are only -0.13% and -0.15% of the baseline value, and
the separation is less than 1% of the baseline value from 2022 onwards, clearly a better outcome than those
attained in the preceding scenarios.

Table 3: Scenario 3: Annual impact on real GDP, unemployment and Debt-to-GDP ratio

Compared to the result from Scenario 2 the negative effects of the shock are relatively minor, and can directly
be attributed to the fiscal policy measures introduced by government. Because the increase in the public
expenditure is not financed by taxes, the annual public budget is affected negatively in the short term. In the
model, this budget deficit is financed by an increase in interest-bearing liabilities, which affects the net wealth
position of the public sector negatively. Compared to the baseline, the choice of an active fiscal policy,
increases the public debt-to-GDP ratio positively. Since debt is a stock it captures the impact of cumulative
processes in the model, and therefore it comes as no surprise that the debt-to-GDP ratio increases as a result
of this policy. Compared to the baseline the ratio increases by 15% points by 2025. In this regard, it is
important to highlight that the public budget comes under further pressure from automatic stabilizer
mechanisms (the result of lower tax income and an increase in social transfers following the decline in

16
economic activity). This automatic deterioration in net wealth of the public sector, even in the absence of
discretionary fiscal policy, should be considered when discussing the cost of active fiscal policy, as the cost of
inaction could be greater. The presently low level of interest rates also significantly lowers the cost of
servicing the debt.

The results from the simulation clearly illustrate that the gap between the baseline scenario and the impact
of the pandemic be greatly mitigated through use of fiscal policy. The suggested policies are a combination
of compensation to firms during the pandemic in 2020 and an increase in the public consumption, especially
in the period of 2020-2022, where the negative effects of the crisis are expected to be the largest.

7 Discussion
The question of whether discretionary countercyclical fiscal policy is back in fashion is ever more relevant, as
the global economy feels the impact of an economic shock, the magnitude of which is expected to be similar,
if not greater than that of the Great Recession. A major difference between the Great Recession and now,
as discussed above, is the acknowledgement of the need to introduce discretionary countercyclical policy, by
both economists and politicians, in Denmark and in a number of major economies. The strategy in many
countries appears directed towards the financial support of businesses and workers in the short run to
compensate a loss in income. From a monetary policy perspective, this has been coupled with additional cuts
in official interest rates – although with limited space to cut with rates already at or close to negative rates.
Furthermore, the access to liquidity for the firms and households has been improved in order to avoid
bankruptcy and forced sales. The principle goal of is to keep the production factors (both labour and the
productive capital) ready to meet the expected surge in demand as the pandemic abates. This strategy is
therefore not to avoid any fall in GDP as such, but to reduce the magnitude of it as far as possible. As seen
by comparing the different scenarios of the simulation, the fall in GDP can be reduced significantly by
increasing the social transfers given to firms to compensate for both the loss of income from the fall in
production and the costs of labour retention. As claimed by the current and a former chairman of the Danish
Economic Council, the size of the fall in 2020 is highly depended on whether the behaviour of private
consumption and investment is affected or not, (Wang (2020)) 16. The results from Scenarios 1 and 2 in this
paper highlight the importance of a whether the shock is a single-period shock or if it exhibits hysteresis.

16
This claimed is also confirmed by a simulation of the model used in this paper, but in order to avoid too many
scenarios, a scenario without changes in the consumption and investment behaviour is not presented in the paper.

17
While this does not affect the magnitude of the initial shock, it clearly affects the recovery phase as shown
in Tables 1 and 2. In both cases, the Danish economy is expected to be affected in the medium term by the
repercussions of the pandemic. The recovery phase presented in Table 2 is depended on the choice of the
value of the parameters in the AR(1) process. A smaller value shortens the time period for which the shock
affects the system, while a large value has the opposite effect.17 Despite this dependency on the size of this
parameter, the overall results from Scenario 1 and 2 are robust.

After the first stage, to keep factors of production intact (the aggregate supply), the second should be to
secure a sharp and sustainable recovery of aggregate demand with the implementation of Keynesian
countercyclical fiscal policy. The effect of this strategy is illustrated in the comparison of the results from
Scenarios 2 and 3. The purpose of step one, to reduce the magnitude of the drop in real economic activity in
2020, can be observed in the substantial improvement of GDP from -5.5% in Scenario 2 to -3.3% in Scenario
3. The deviation between Scenarios 2 and 3 is dependent on the size of the fiscal stimulus, but the overall
results are robust to different choice of stimuli. The second stage is also accomplished in the model, as
illustrated by the relatively faster recovery of the economy in Scenario 3 relative to Scenario 2. Furthermore,
the gap between the real GDP in the baseline scenario and Scenario 3 closes to near-level by 2024, while a
negative gap persists in Scenario 2 – where fiscal policy is not employed to combat the economic loss. This
result, one the one hand, clearly highlights the need for a countercyclical discretionary fiscal policy, especially
during a crisis. On the other hand, it also raises the question about how to finance this policy and if this policy
creates a risk to fiscal sustainability in the longer run. To answer this question, it is important to consider
that the public budget is already under pressure during a recession as a result of automatic stabilizers. With
relatively strong automatic stabilisers, as in Denmark, a powerful shock or crisis can drive substantial negative
changes in the public budget and the corresponding level of public debt, as seen in Scenario 2. An evaluation
of the cost of a discretionary policy should therefore take these aspects into account. As presented in Table
3, the effect of fiscal policy clearly affects the debt-to-GDP ratio of the public sector. Despite an increase in
the debt-to-GDP ratio of around 15% points compared to the baseline scenario, this should not pose a risk to
the financial position of the public sector in Denmark. In 2019 the net wealth of the public sector turned
positive, provides Denmark with the opportunity to access both foreign and domestic debt at very favourable
interest rates. The long-standing stability of the fixed-exchange rate regime, and low public debt position
also make Danish public debt an attractive substitute for Euro denominated debt instruments, which allows
for greater proportions of debt to be domestically denominated. Furthermore, the current situation clearly
raises the somewhat rhetorically question of if not now, then when should Denmark use active economic

17
To keep the process stationary, the value of the parameter is assumed to be smaller than 1.

18
policy? As stated by two former chairmen of the economic council (Scheer (2020)). The Danish government
appears thus to be in a position where it can choose, to paraphrase Keynes, to take care of unemployment
and to let the budget take care of itself as the government revenues and expenditures benefit from the
reversion of economic stabilisers.

8 Concluding remarks
Once again, the global economy faces great difficulties. Just a decade since the start of Great Recession, from
which many economies have yet to recover, the COVID-19 virus pandemic has triggered a second collapse in
global production. The full extent to the decline is presently unknown, but unfortunately, it seems probable,
as indicated by the IMF and others, that the global economy could experience a recession similar to if not
worse than the last one. There is additional uncertainty on the expected duration of the both the health
pandemic, and the economic consequences. Hopefully, the prognosis of the IMF of a relatively quick recovery
by 2021 is correct. However, as the present analysis shows, presenting Denmark as a case, it could take years
for production and employment levels to recover to pre-crisis levels. The analyses presented above is, as is
necessary, subject to uncertainty of a fundamental or an ontological kind. For now, with the range of
conditionalities and the extent of global interdependencies, the future is truly unknown and unknowable.
This is the case not only the case for Denmark but for all countries. The estimated shocks are scaled to
represent a middle ground between optimistic and pessimistic possible outcomes, and both the negative
effects of the pandemic and the strength of the response could be stretched in either direction18.

Be that as it may. It seems certain that all countries have implemented some form of policy to dampen the
negative economic impact by the COVID-19 virus pandemic, particularly of an expansionary nature. Similarly,
many economists – mainstream and non-mainstream alike – advocate that present responses should further
be supplemented by traditional fiscal stimuli to boost aggregate demand, and to bring economies back to or
close to their potential output levels. Furthermore, the COVID-19 virus recession may regenerate a most
needed focus on the crucial importance for countries to have collectively funded and comprehensive social
protection systems, as argued above.

18
In an analysis made by the Danish Central bank published on the 1st of April, the Bank estimates three runs ranging
from a rather quick and smooth recovery to a more sluggish and slow recovery. As such, they give estimates between -
3% and -10% in the Danish GDP for 2020.

19
In the acknowledgement of the need to use monetary and especially fiscal policy changes to try to combat
the devastating economic consequences of a recession (be it the Great Recession or the present one),
economists and politicians alike seem to act as Keynesians. As such, Keynesianism is alive and kicking19. After
all, Keynes might perhaps win the battle of macroeconomics in the longer run.

19
However, concerning mainstream macroeconomic theory as well as mainstream methodology if (and how) significant
changes are going to be implemented in the future is still questionable. Hopefully, mainstreamers will acknowledge that
it is time to open up for more pluralism in macroeconomics. The understanding of the NNS and their DSGE models is
not enough in itself to cope with the complexities of real-life economics.

20
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